What is Return on Investment?

Return on Investment (ROI) is a performance measure used to assess the profitability of an investment. In the context of business sales, ROI is a useful metric which gauges the percentage return that a buyer of a business expects to receive on the annual profits of a business compared to the total costs from buying the business. For example, a business with $100K of annual profits and costs the buyer $300K results in a 33% ROI ($100K/$300K). Buyers of small businesses may expect an ROI of about 33-50% while buyers of larger businesses may expect an ROI of about 16-33%. Prospective buyers often use ROI as a way to easily compare the ROI of different business opportunities. In order to properly use ROI, one must properly measure the profits of the business and the cost of buying the business.

Determine Adjusted Owner Benefit

The adjusted owner benefit measures the true economic profits derived by a working owner, and should be used when calculating the ROI of a business opportunity. The adjusted owner benefit is almost never the same as the net taxable income on a tax return or the net ordinary income on a profit and loss statement. Instead, the adjusted owner benefit includes non-cash expenses (such as depreciation), interest and debt payments (assuming the business is conveyed debt-free), the owner’s salary, and personal expenses of the owner that flow through the financial statement. The adjusted owner benefit also includes any other non-recurring expenses or adjustments that would not be the responsibility of the buyer. The adjusted owner benefit is the cash flow that a buyer may expect to receive from the business, and should be used when calculating a buyer’s expected ROI.

Owner’s Role in Business

The adjusted owner benefit of a business must be viewed within the context of the owner’s role in the business. An active owner-operator who has special skills instrumental to the business will be difficult to replace for most buyers without major risk and replacement costs. Likewise, an active owner-operator who has personal relationships with key customers, employees, or suppliers will also be risky and costly for most buyers to replace. As a result, businesses with more passive or absentee owners are valued higher than similar businesses with active owner-operators. Buyers of businesses must gauge the seller’s role in the business in order to properly determine the owner benefit that the buyer would receive. A lower adjusted owner benefit from the buyer’s point of view results in a lower ROI.

Growth After Inflation Affects ROI

When comparing the ROI of business opportunities, it is important to consider the historical and projected growth of the profits of the business after accounting for inflation.
A business that has shown historical growth in its financials is likely to continue growing so long as its competitive advantages remain intact after the sale.
The projected growth of a business raises its ROI in future years since the buyer’s expected cash flow will rise in future years.
This makes the business opportunity more attractive for a buyer.
In contrast, a business with historically declining profits is likely to have a lower ROI in future years.
It is for this reason that investors should cautiously measure the current ROI of a business opportunity.
The ROI of a business for sale must be viewed in context of its future growth prospects (if any).
Whether or not a business is expected to grow its profits in the future, the inflationary environment must also be examined.
Inflation is the decreasing purchasing power of money over time.
Inflation affects the present value of a business’s future earnings stream.
Let us assume that inflation is expected to grow 6% next year.
If the profits from a business opportunity is expected to grow by 10% next year, then the true growth rate of the business is actually 4% (10% growth rate – 6% inflation).
Inflation must be deducted from the nominal growth rate of a business in order to decipher its true growth rate.

Cost to Buyer of Investment

When calculating the true Return on Investment of a business opportunity, the adjusted owner benefit should be measured against the total costs to the buyer of buying the business. The buyer’s total costs include the working capital needs of the business, or its short-term funding requirements. Working capital includes cash, inventory (goods available for sale), and accounts receivable (money owed for billed services). Businesses with high working capital needs carry large amounts of cash, inventory or accounts receivable, which represent a real economic cost to potential buyers. The normalized working capital needs (including required cash on hand) must be included in the total cost of buying a business when calculating ROI. This is the case even if inventory or accounts receivable are retained by the seller or sold separately.

Leverage Increases ROI

Leverage refers to using debt as a way to increase investment returns (or ROI). Buyers of businesses frequently use external funding backed by the Small Business Administration (SBA) as a way to finance the purchase of businesses. Doing so dramatically increases the ROI for such buyers. Consider a buyer paying $1M (including working capital) for a business which will generates an annual owner benefit of $300K. This results in a 30% ROI ($300K/1M). Now assume the same buyer gets a 7(a) SBA-backed loan to finance most of the deal. The bank requires a $100K deposit and gives the buyer an SBA-backed $900K loan at 10% interest for a 10 year term. The buyer now will have cash flow of $153K after principal and interest payments on the $900K loan. Since the buyer’s outlay of capital is so low, however, the ROI is now an astounding 153% ($153K/$100K). With more leverage comes more risk so buyers should always beware the power of leverage.

Return on Investment is a useful metric that allows buyers of businesses to easily compare the profits they may expect to receive from different business opportunities compared to their expected acquisition costs (including working capital needs). The ROI should always be placed in the context of the past and future growth rates (after inflation) as well as the role of the owner in the business. These factors must be analyzed in order to determine the future cash flow to a buyer.

Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.